Delhi School of Economics
Department of Economics
EC001: Microeconomic Theory (Part C)
Problem Set 5 (Choice under Uncertainty)
1. Consider the following lotteries
1 1 1
A = Rs.100 with prob , Rs.50 with prob , Rs.20 with prob
3 3 3
3 1
B = Rs.100 with prob , Rs.20 with prob
4 4
1 3
C = Rs.100 with prob , Rs.20 with prob
4 4
D = Rs.50 with prob 1
and the following preference orderings
P ref erence ordering 1 : B≻D≻A≻C
P ref erence ordering 2: C≻A≻D≻B
P ref erence ordering 3: B≻D≻C≻A
(a) Which of these preference orderings cannot be represented by a von Neumann utility function?
(b) Which of these preferences cannot be represented by a von Neumann utility function if we make
the additional assumption that more money is preferred to less?
2. A risk averse farmer has preferences described by the utility function: u(y) = log y, where y is the
market value of his crop (and hence his income) in rupees. In a normal season, y = 100 but in case
there is a flood, Rs 75 worth of crops will be destroyed and the farmer will be left with only y = 25.
It is known that the probability of a flood is 12 .
(a) Derive the coefficient of absolute risk aversion and the certainty equivalent of the lottery faced by
the farmer.
(b) An insurance company is selling crop insurance at a premium p, i.e., the farmer can insure any
amount x (up to Rs 75) of the crop value by paying Rs p per rupee insured. Derive the farmer’s
demand function for insurance, x(p).
(c) The insurance company has administrative costs of Rs 5 per client. This amount is independent of
how much insurance the client buys. The government wants to regulate the insurance market by
setting the insurance premium p so that the company just breaks even, i.e., earns zero expected
profit. What value of p should the government choose? (It is enough to derive an equation in p
whose solution will give us the answer. You do not have to compute an exact numerical value).
3. An agent√ facing retirement has preferences captured by the Von Neumann Morgenstern utility function
u(c) = c, where c is consumption after retirement. The agent has a total saving of w, which he can
hold partly in the form of a risky asset and partly in the form of a safe asset (e.g. cash). If the agent
invests x in the risky asset (0 ≤ x ≤ w), he receives 2x with probability α and 0 with probability 1 − α
upon retirement. If he invests y in the safe asset (x + y = w), he receives y for sure upon retirement.
Retirement consumption c is the sum of the returns from the safe and risky assets.
(a) Solve for this agent’s optimal portfolio choice, i.e., how he will allocate his savings w across safe
and risky assets.
(b) For what values of α is the entire saving invested in the safe asset? For what values of α is it
invested entirely in the risky asset?
(c) Suppose there is a financial derivative market which offers the opportunity to bet at fair odds
against the event that the risky asset will produce positive returns, i.e., if the agent bets an
amount z, he must pay z if the return is positive but will receive pz if the return is 0, where p is
such that the issuer of the bet makes zero expected profit. Calculate the amount invested in the
risky asset, the amount placed on bet and the increase in consumer utility from having access to
betting.
1
4. Consider another portfolio choice problem. An agent with wealth w must allocate amount x ∈ [0, w] to
asset A and the remaining to asset B. Asset A either doubles the amount investmented or reduces it
to zero, each outcome being equally likely. Asset B either trebles the amount invested in it, or reduces
it to zero, again both outcomes being equally likely. The returns from assets A and B are statistically
uncorrelated. The agent’s consumption c is the value of his portfolio after all returns are realized, and
his VNM utility function is u(c) = ln c.
(a) Solve for the optimal portfolio choice.
(b) Give some intuition why the agent will choose to invest in both assets even though one has higher
expected returns than the other.
5. Monty Hall, an American TV personality, used to offer contestants the following choice on his televised
game show. The contestant would be positioned before three closed doors, one of which has a valuable
prize behind it (e.g., a car), while the other two are empty. The contestant is then asked to choose
one door, and if the prize object happens to be behind it, he will win it. However, after a choice was
made, Monty would typically pull a stunt. He would open one of the remaining two doors, reveal it to
be empty, and then ask the contestant if he wants to stick with his choice or switch to the other closed
door. Does switching increase the chance of winning? Carefully spell out your assumptions.